In a hard place, fund investors grab for rocks

SAN FRANCISCO (MarketWatch) -- The third quarter for stock mutual-fund shareholders went something like this: Easy money, followed by easy-to-lose money.

By the end of these 13 tumultuous weeks, most U.S. stock fund categories were either under water or barely breaking the surface. Perhaps most importantly, the shakeup has given the market clear new leadership that is making its mark on investors in a big way -- literally.

Diversified funds rose 1.3% on average through Sept. 27, according to preliminary results from fund tracker Lipper Inc. That was a fraction of the 6%-plus gain stocks posted in the second quarter, but an impressive recovery from the beating they suffered less than two months ago.

The push into positive territory, coming in the final days of the quarter, brought the Dow Jones Industrial Average
DJIA, +0.45%
within striking distance of its record 14,000 peak reached on July 19. The comeback masked but could not erase memories of the sharp downturn that so unsettled U.S. markets this summer.

Investors seeking shelter found it in natural-resources funds, up 8%. The energy-dominated sector was strong for the second consecutive quarter. The worst: Small-cap value, down 5.3%. Small-cap funds in general felt the brunt of the blow; only small-cap growth stayed afloat with a 1.9% gain.

The sinking of small-company stock funds after several years of solid returns gives new meaning to the term "cap size." Moreover, the slippage signals a sea-change in the U.S. market that could affect fund investors' returns for this year and perhaps longer: The emergence of large-cap growth stocks.

"Large growth has been a dramatic underperformer," said Mark Balasa, a financial adviser who has been adding big growth stocks to clients' portfolios. "It's large growth's turn to be in the sun."

Large-cap growth funds enjoyed a 6.4% quarterly gain, the best showing among the major stock-fund categories. Multicap growth funds, which also lean toward large-caps, ran a close second, up 5.4%, while midcap growth funds tacked on 4.4%.

The quarter's top performer, in fact, was midcap-growth CGM Focus Fund
CGMFX, +1.63%
which soared almost 31% in the period on the strength of manager Ken Heebner's high-octane positions in energy companies such as Potash Corp. of Saskatchewan Inc.
POT, -2.50%
and McDermott International Inc.
MDR, -1.40%

The most popular growth-style offerings also sailed smoothly, if not quite as swiftly: American Funds' Growth Fund of America
AGTHX, +0.44%
added 4.4%; Fidelity Contrafund
FCNTX, +0.66%
was up 7.4%, Fidelity Growth Company Fund
FDGRX, +0.73%
gained 9.1%

"So far, so good," said Ronald Canakaris, manager of Aston/Montag & Caldwell Growth Fund
MCGFX, +0.71%
which gained almost 10% in the period.

"Things have unfolded like we would have hoped," he added. "Large-cap growth stocks are attractively valued and well positioned for a changing global economic mix. These favorable conditions should be with us for a considerable period of time."

Crunching numbers

The breakdown of key pillars supporting the U.S. economy and the challenges this poses to U.S. investors are by now well known. For much of the year, concern about subprime mortgage loans and hedge-fund borrowing was pinned against a dark backdrop of slower corporate earnings growth, fickle consumer spending, inflationary signs and rising interest rates. The hinges came undone in August, sending global markets reeling.

It was, to use Wall Street's euphemistic parlance, a major "disruption." Others might call it panicked selling. Market volatility spiked, credit got crunched and stocks took a hit that stunned even veteran investors.

The Federal Reserve and other central banks stepped in with money to maintain liquidity for borrowing and lending, but the Fed had to cut interest rates on Sept. 18 before investor confidence returned in any meaningful way, though many strategists weren't fully convinced. See related story on bond funds' outlook.

"The Fed lowers rates and everything's fine -- I'm not sure life is that simple," said Bob Doll, chief investment officer at BlackRock Inc.

"The Fed has a balancing act to do," Doll noted. "They've said they're going to fight economic weakness and let the other stuff -- the dollar and inflation -- go, but keep an eye on it. For the moment, things are OK, but we're between a rock and a hard place."

Credit-sensitive sectors showed the strain. Financial-services funds fell 3.7% in the quarter. Real-estate funds managed to gain 1.5%, reversing a 7% second-quarter slide but still a weak showing for a onetime market darling.

The troubled financial sector is weighing on the benchmark Standard & Poor's 500 Index
SPX, +0.64%
S&P 500 companies, reflecting the largest U.S. businesses, are expected to post drab year-over-year operating earnings growth of 2.4% in the third quarter. Growth hasn't been so anemic since the first quarter of 2002, according to S&P.

"You can't have a good earnings period without the financials," S&P analyst Howard Silverblatt told clients in a research note.

The strongest S&P 500 sectors include telecommunications, technology and health care. S&P analysts expect the index to average double-digit earnings growth again beginning in the fourth quarter, although the financial-sector's contribution should be minimal.

Supersize me

Sluggish earnings and a bifurcated market are the seeds of growth investing's resurgence -- and an important reason why large-cap growth funds may continue to outperform.

Financial stocks, one of the S&P 500's cheapest sectors on a price-to-earnings basis, have been favorites of large-cap value fund managers. Many value buyers also have filled up on consumer stocks, which are relatively inexpensive but are directly tied to housing, jobs and inflation -- potential knocks to retail spending should they head the wrong direction.

Technology, telecom and health care, three areas of the market where many large-cap growth managers have meaningful positions, were among the quarter's bright spots. Technology funds finished up 6.7%, while telecom funds rose 4.3% and heath-care funds added 3.7%.

"You had very little difference between growth and value based on valuation," said Chris Cordaro, chief investment officer at money manager Regent Atlantic Capital LLC. "If good growth companies are similarly priced, why would you buy the company with financial distress?"

The shift to growth stocks is in keeping with a market worried that weak earnings and wallet-conscious consumers could tip the economy into recession, despite the Fed's best efforts. When earnings growth is abundant, stockholders are more comfortable taking risks in companies that are disliked, or narrowly channeled or small in size. Investors turn about-face when earnings growth appears scarce, embracing shares of cash-rich companies with little to no financing needs and the muscle to deliver the goods.

"It's easier for Procter & Gamble
PG, -0.26%
and Medtronic
MDT, +0.34%
to keep their earnings on an even keel," he added, referring to two of the fund's investments. The portfolio also has significant exposure to technology and telecom companies, including Microsoft Corp.
MSFT, +1.25%
Google Inc.
GOOG, +0.57%
and AT&T Inc.
T, +0.09%

In addition, many of these stalwarts on growth managers' lists are global enterprises that enjoy diverse sources of earnings. In some cases, a substantial portion of those earnings are in currencies other than U.S. dollars. With the dollar weak, revenue brought back to the U.S. will be worth more in dollars, boosting a company's income. About 45% of S&P 500 earnings now come from outside of the U.S.

"Economic growth has been stronger in Asia and to a certain degree in Europe," Puglia said. "Large multinational companies that have the ability to access growth in those economies have benefited."

Pockets of worry

Many fund managers and investment advisers have heard the message. They're buying larger-cap stocks, focusing on high-quality businesses in top financial shape, and taking advantage of the slumping dollar by emphasizing multinationals and non-U.S. companies. But there's a nagging sense that even these moves won't provide enough of a cushion going into the new year.

"I'm a little bothered by some of the speculative activity we're seeing in a handful of stocks," said Jerry Jordan, manager of large-cap growth Jordan Opportunity Fund
JORDX
which gained more than 7% in the quarter.

Highfliers such as Chinese Internet firm Baidu.com Inc.
BIDU, -0.63%
Wynn Resorts Ltd.
WYNN, -2.79%
and Research in Motion Ltd.
RIMM
are three examples that Jordan is watching from afar. "They have big growth but the multiples are getting high," he noted, "which means there's not a lot of margin for error."

"What I'm worried about is whether I'm underestimating the extent to which housing and consumer weakness becomes more of an issue," added Brendt Stallings, manager of TCW Growth Equities Fund
TGGEX
a midcap growth offering that rose more than 17% in the quarter.

"There is going to be a lot more noise in the market over the next six to 12 months," he added. "There will be bad news out of financial services, and some of the headlines will be difficult."

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